Like many value-focused investors at this time, I find the market highly valued. As a result there are not too many quality value opportunities to be found. I’ve been focusing more on opportunities in out of the way corners that don’t screen well, special situations, etc. I’ve found retail intriguing lately because it has been hammered down so much– rightfully so in many cases. But there is often a baby thrown out with the bathwater. Today I discuss a retailer that I think has been unfairly punished for a variety of reasons: Joe’s Jeans. But first, quick thoughts on the retail sector at large.

This is not your Father’s retail market

Retail has been in the doghouse lately. The Internet, and specifically Amazon, dramatically changed the specialty retail sector. In the past the retailing concept was pretty simple. Build an economically sustainable concept at the store level, scale it to 20-30 stores to make sure it works, and then roll it out nation (and world) wide. That paradigm is gone. Staples, Radio Shack, Linens ‘n Things, Bed Bath and Beyond and others all have recently illustrated the difficulties with this model. Of course, the poster child for over-building is the Gap, which carpeted the world with stores in the 80’s and 90’s only to spend the last decade and a half downsizing (full disclosure: I worked for the Gap for a large portion of my career). Only recently have they begun to recover and develop a sustainable model.

I think successful retail investments in the future are going to require several key attributes:

Small but growing store base: some of the companies mentioned previously may ultimately turn out to be successful companies and investments. But “right-sizing” your fleet is an expensive and distracting business. It is far better to look at smaller retailers that can still expand selectively.

Successful online presence: it is not enough to just pop up a web site. “Omni-channel” is the current buzzword for retailers, but only a few do it well. This requires a great focus on engagement and logistics to ensure that the on-line and store experiences are seamless.

Differentiated product: Increasingly people will only visit a store or website for a product that can’t be found elsewhere.

Recognized Brand: Underpinning all of this is a brand that people are willing to engage with.

Joe’s Jeans

I think Joe’s fits the bill well in these categories. They are a small company that designs and sells premium denim. The company has a wholesale segment representing 81% of revenue in 2013 and a retail segment contributing of 19% of revenue. They operate 14 full price and 20 outlet stores. Three main players ably run the company:

Marc Crossman: CEO since 2006. Associated with the company since 1999.

Joe Danahan: head designer and Creative Director since the current fashion denim division created in 2001.

Hamish Sandhu: Chief Financial Officer since 2007.

They are fairly invested in the company, with Marc owning 3.8% and Joe owning 17.2%.

If you listen to their presentations and conference calls, you will quickly see that Marc and Hamish are operators and Joe is the creative talent. I like this arrangement. The operators run the company effectively and (hopefully) profitably. And Joe gets to focus on developing and marketing great product. This will be important later in the discussion.

Joe’s has a strong brand for a small company. They did $118m in revenue in 2012 and $140m in 2013.

The situation

In 2013 Joe’s did something out of character – they bought a private competitor: Hudson’s Clothing. The deal closed in October 2013. The market thought this was a bad idea and the stock shortly lost about a third of its value, falling from $1.60/share to $1.10. I don’t agree with the market reaction. I think this will be a very good move.

In order to fund the acquisition, they took on debt. A lot of it and at not such great prices – that’s why I think this is out of character. Joe’s was debt free for nine years previously. The debt consists of a term loan of $60m at 10.75% + interest due in 2018 and pre-payable after 2016 with no penalty. Plus, convertible notes in aggregate of $32m with an effective interest rate of 10%. If fully converted at $1.78/share the notes would represent 18.2m shares.

Joe’s basically doubled the size of their business with the acquisition. Since Hudson’s was private previously, we don’t have great details on revenue or profitability, but there was reference made to almost doubling revenue with the acquisition. I’ll assume an integrated run rate of $200m in revenue.

Joe’s released Q2 earnings on July 10 and revenue increased 56% to $48.2m. Operating income increased 55% to $3.3m. Interest expense was $3.35m so they are essentially operating at breakeven.

The thesis

When Marc and Hamish talk about the acquisition of Hudson, they are very specific about the benefits. There will be substantial cost savings from moving production of Hudson product to Mexico. This is what they did for Joe’s and they seem to have very specific numbers for what they can save. They have quoted a full year run rate of $10m in savings. I think they are being conservative. I think they will use the productions savings to pay off the debt. What I love about these guys is that they don’t talk about “synergies” or “back office efficiencies”, they talk about production saving. In fact, they claim they will run the two brands separately for the foreseeable future.

So the thesis is pretty simple:

The size of the company has doubled

Joe’s is breakeven with their high interest expense

$10m production savings annualized

Pay down debt in 4-6 years

Valuation

I’m going to use a common sense valuation here. If things transpire as described above, in 3-5 years, you will see a company that has $220-$250m in revenue. Assuming a net income margin of 5% - 10% and 87m fully diluted shares:

Low side estimate: 5% of $220m = $0.13/share

High side: 10% of $250m = $0.29/share

Putting a modest 15X multiple and we could see share prices in the $1.95 to $4.35 range. At a current price of $1.20, I think this represents acceptable upside for the risk.

What could go wrong?

Debt: I think this is the most obvious problem. This is mitigated by their historically debt free balance sheet. I.e., I think they will strive to pay it off quickly.

Production: moving production is not without complexities. This could cause short-term supply chain disruptions that could impact sales.

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